Wednesday, January 20, 2010

A long while ago I did some work on Rent-A-Center – a company in the difficult and arguably immoral business of “rent-to-buy”. Rent-to-buy is how you buy a TV or a couch on credit when you do not even qualify for a credit card. The business model is disarmingly simple. You have shops with 200-300 stock keeping units (running the shop is not the business). They sell things on a very simple mark-up basis. The advertised price of the thing (a TV, a couch) in the shop is 100 percent mark-up on the invoice price. However the real price is 48 monthly (or more realistically 208 weekly) instalments based on recovering 400 percent of the invoice price. If the TV wholesales for $1000 then the monthly instalments add to $4000.

The shopkeeper is not remunerated based on the sales of the shop – but rather how well they maintain “credit”. These are RENTAL contracts – so that the ownership of the TV does not pass on “purchase” but only after the payment of the last “rental payment”. This gives the shopkeeper the right to repossess the TV after a single missed payment. And if the shopkeeper is savvy he will turn up to collect the couch during the Superbowl (when he can be reasonably sure his customer and friends are sitting on it drinking beer and can probably scrounge up the cash to keep it). This differs sharply from the credit card industry – the credit card company has no charge over the assets sold to you on credit card.

Default as such does not exist. If you don’t pay your rental payment you lose possession of the couch – but you have not defaulted on any legally binding credit agreement. The store will simply sell the couch again trying to recover the amount that remains outstanding on the rent-to-buy contract.

Whatever – this looks like usury – and some of the “contracts” clearly had interest rates above 200 percent per annum. They made the treadmill of credit card debt look mild. Regulators have been taking pot-shots at Rent-A-Center for a while but without much effect. Here is an example.

Still we are talking about regulating credit cards – and nobody much seems to mention Rent-A-Center despite the far more usurious nature of the business.

I went to visit this company determined to short the stock. I did not. The company looked like a money-machine even if it appeared to breach the intention of pretty well every consumer protection law I had ever seen. I could not see what-if-anything broke the model. Moreover the customers understood just how usurious the business was. It was not like credit cards where the hidden overdrawn and late fees – things the consumer was suckered into – were the driver of the model. This was honest usury.

But it was the nature of the people I met that most stuck in memory. This was a business where if Jesus was alive he would pull down the Temple over them. It was precisely the sort of business the bible rails against. It offended my decency. But the people were lovely. I met management and a store owner – and – frankly they seemed exactly the sort of people you would like to have Friday drinks with. I liked them.

This alarmed me of course – because I expected them to be scum. And maybe they are – but I couldn’t tell. They were the sweetest usurious bastards (notwithstanding allegations in consumer complaints about the company).

I know someone who lost a lot of (client) money in a famous financial fraud. He met the principal and described him as “one of the nicest guys I have ever met”. Indeed the disconnection between how people seem and what they do is central to many frauds – and indeed to much of the world.

Warren Buffett claims in his letters to have a judgement of people as good as his judgement of businesses. [He thinks he has got businesses wrong more often than the management that sold them to him.] That is truly amazing and perhaps the most under-recognised skill of Buffett.

He has however given us a few clues as to how he does it. One guy he really liked was late to a meeting because he spent time looking for a parking meter with unused time. More generally he likes people who are cheap, smart and opinionated. Its just that when I am like that nobody invites me to dinner let alone describes me as “one of the nicest guys I ever met”.

i too have looked at rent a center, and (luckily) made a modest amount of money shorting it for brief periods on two occasions in the last year and a half.

my thesis was that in the economic downturn their customers would no longer have the appetite or capacity for these very expensive deals for highly discretionary items such as big screen TVs (their biggest seller), and that the company's high fixed cost base would then cause its cash flow to decline dramatically.

but i was wrong...while their sales were off a little bit, it seems that for the most part RCII's customers just can't do without their toys, even in the worst economic conditions. So the company continues to generate buckets of cash.

btw, their same store sales growth pales in comparison to that of their main competitor, aaron's, so maybe there's another angle to the short case.

Warren Buffett is absolutely clear that the guy who went looking for the parking meter was simply the best guy he had ever done business wtih (at least until that time). It was the guy who sold him and ran his core insurance sub - National Indemnity.

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RCII is frighteningly profitable - but I said up front that it was a difficult business - and it is. You need to construct something with the right level of sweet and asshole. That is not easy to do. Culture is hard to duplicate - even if it is an evil culture.

This was the business model of Radio Rentals in the UK. Their securitisation - box clever - was one of the worse UK ABS deals before the crunch. It turned out when the RR failed that they did not have good records of who actually had the TVs and VCRs. Cue massive writedowns for those who had bought paper backed by the rental receivables. The lesson being that you can be a usurous bastard and still lose money...

How is this usury? There is no debt involved; no payments are due after the item has been contractually reclaimed.

As capital is to check-cashing outlets, so this is to household goods. Yes, it's true that these companies take advantage of structural flaws in the economy, and prey on the lower and lower-middle classes -- but that's a symptom of wage stagnation and education (innumeracy), not a cause.

(a), Its usury because they behave like loan sharks. They - according to complaints - kick people's doors in to get the TV...

AND

(b). Yes I know it is the business model of MANY people who have blown up (including Radio Rentals). That is why I went there determined to short them. But this company grows relatively slowly (it is easy to fake data with fast growth and hard with slow growth) and the evidence is that they collect.

Fast growth - as per the competitor - scares the willies out of me. Slow growth tends to indicate honest accounting.

RCII doesn't seem to be that great of a business. Their returns on capital historically doesn't seem to be that high.

RCII rent crap like TVs, computers, furniture, that have very fast depreciation schedules and therefore small recovery value if you retrieve the collateral. Plus, they face a high propensity for default and a high collection cost per default because they are dealing with a very small dollar amount per transaction. Imagine if you had to send 2 guys per $600 "loan" who spend hours harrassing the defaulted person and probably still won't get their money back.

In this business, what can you do except charge really high effective interest rates? You basically have to make an enormous amount of money on the few people who don't default, and break even or lose money trying to collect from the majority of people who do default. Sounds like a terrible situation to me.

Even worse, you can't simply raise the interest rates to boost margins. One, you get even more legal heat. Two, raising interest rates increase the probability of default so at some point it's completely self defeating.

It's not a matter of honesty or usury. It's a business model that can only survive in the form that it does. If a poor person can't qualify for a credit card but wants a big screen TV, he basically has to pay the price.

Having worked closely with similar businesses in Australia, a few key points struck me with regard to their high levels of profitability and seeming lack of competition.

Firstly, the industry generally carries with it significant regulatory risk. Aside from personal views on the morality of providing "lending of last resort", politicians and regulators will never lose friends cracking down on usurers. Bureaucratic careers have been built on a platform of bringing these people to account. As an aside, for whatever reason regulators in Australia have generally been more pro-active in pursuing these operators than those in the UK and US - Motor Finance Wizards withdrawn IPO in 2007 due to an ASIC investigation being a relevant recent example.

Secondly, funding these businesses (especially in Australia) is quite difficult. The loan-book profile is generally reasonably short term, and inherently sub-prime. Initial growth funded by equity is relatively easy (especially when equity investors see the cash generation potential of the business). However, growing the business at later stages using debt can be difficult. A review of Amazing Loans (AZD AU) attempts to fund the expansion of their business is instructive in this regard.

The fact is that there will always be a demand for finance of various kinds (motor vehicle and household goods predominantly) from borrowers of low credit quality. Well run operations of this kind cater to a genuine and poorly served need within the market. Their ability to charge the rates that they do stems from the lack of competition from high volume players.

However, the close scrutiny of regulators, and issues with funding the operations should keep healthy risk premiums built into share prices.

Somthing seems a bit off at nakedcapitalism? When I click older pages to reread the article about the UK following Iceland, I get 4th Jan and prior posts! That is page 2. I have been unable to read the article in the FT as I am told the server is under too much load. Yet I am asked to subscribe if I try to access any other article!!!!What can affect both sites?

Radio Rentals and earlier models on H-P etc were started in the twenties in the USA. It was ever thus? Those who have no credit history get slugged with higher rates. Incidentally, the business model will be heavy on interpersonal contact and therefore employment just when the economy is at its worst. That may be why it is not making much, or else the managers have secret commissions? Also don't forget that money laundering becomes more significant when the economy drops. Drug dealing is one of the last things to falter, buy brewers etc? Given the profile it seems more suited than a chain that sells kebabs and launders drug money?

I wouldn't suggest in any shape or form that rent-try-buy business models are ALL usurious bastards charging exorbitant rates to uncreditworthy customers. There are some highly profitable and notably well-run public businesses in Australia in this space such as Thorn Group, Flexirent, Silverchef, Thinksmart. They all earn solid returns on capital with minimal defaults and im sure if you asked their customers about the contracts, they would attest to their complete satisfaction with their rental contracts. These businesses earn decent growing returns and have high annuity-type cashflow but I think the key to all their models (besides their important credit policy) relates to their funding and whether they earn a decent spread between their WACC and ROCE. These 'finance' businesses are highly capital intensive and they continually need to put up more to earn more. While there are not many physical barriers for competitors, to get funding for the returns and risks associated with establishing a rental book diminishes the possibility that too much competition will eventually render diminishing returns. Its not the type of business to salivate over, and I certainly can't speak for the US company mentioned, but the ones in OZ are distinctly different.cheersJonathan

John: not sure if you know the case already, but talk about Rent-a-Center and consumer protection reminded me of one of the great moments of American judicial activism: Williams v. Walker-Thomas Furniture Company. Basically the company had the RaC business model plus cross-collateralization if you took multiple items and maintained any outstanding balance. Mrs. Williams rented items and paid her bills for years, but eventually they sold her an expensive stereo and then repo'd everything in her house when she couldn't pay for it. There was no law against this type of contract and the lower court said there was nothing they could do, but the appellate court ruled that some contracts could be held unconscionable even without a specific law banning them (based on disparity of bargaining power/information + terrible terms). So there are at least some limitations on usury in the US, although they are indeterminate and infrequently applied.

Responding to Josh: I think Rent-a-Center does face a fair amount of competition, most obviously from layaway and store credit cards, but also from smaller merchants on the same model. I would guess that they dominate some markets because there aren't that many customers with no access to better credit terms and they're good at what they do. Also, profit margins are going to be higher in nasty businesses - not as high as in the illegal ones, but the reluctance of decent people to participate in a field increases profits for those who don't care. Depending on your politics you might have different opinions of these fields, but there's more money to be made in cigarettes, guns, alcohol, porn and usury than in no-kill puppy shelters and alternative weekly newspapers that do incisive reporting on local politics and highlight the best new bands.

"More generally he likes people who are cheap, smart and opinionated". That seems to describe Buffett himself. I often observe people liking/trusting people like themselves, or having some common thread. I think it is less of a clue for us, but it shows that Buffett (like all of us)likes to justify himself.

Great question, Kalish! “So, if they’re making such fat, immoral, profits, why doesn't competition emerge and drive down these margins?” I work at RAC and, you’re right… we don’t get driven out of business and our prices don’t get pushed down because our profits are about the same as retailers and our prices reflect the cost of our business. (I just Googled this and found: http://www.nasd100.com/2010/01/ranking-900-us-consumer-stocks-by-profit-margin-as-of-162010.html. We’re 217 on the list with plenty of retailers with higher profit margins listed above us.) Our business costs are just different and what our customers get from using us is different, too.

Yes, selling to customers who don’t have credit has a much higher business risk and we spend our labor hour dollars making sure weekly payments are made. Since customers can move in and out of the rental, we have significant expenses covering the cost of deliveries including trucks, gas and labor hours to drop off and pick up merchandise and then repair and refurbish the products. Since we maintain products while on rent, we have those costs, too. Our store teams sell, drop off and pick up merchandise, so it’s our same coworkers who maintain relationships with our same customers from beginning to end.

Our customers use us because, even though they’re hardworking people, they usually have limited resources and they need products in a way that they can actually pay for them. We take small payments for items and include services in a way that makes life more manageable for them. Delivery, service & setup are included in prices, customers can return an item at any time for no penalty, w/the pick-up being no extra charge and then, whenever they want the item back, they can pick up the payments where they left off. (Try to do that at Wal-mart and see how it goes over! ) If they pay things off earlier it ends up costing them far less. In fact, I think only about 5% of our customers purchase their merchandise by making the minimum payment ‘til the end of the agreement. Most choose the early payoff options.

I do agree with one thing in this post, though… that so many of the people who work at RAC are great people. :)

Maybe it's the libertarian in me, but I'm not sure I understand your gripe.

You say that the terms are fully disclosed up front, and that the buyers understand that they are paying (for example) $4,000 for a $1,000 TV.

If somebody asked me if they should enter such a contract, I'd say no -- save up for discretionary purchases rather than buying on credit.

But apparently they choose immediate gratification and a higher price over deferred gratification and a lower price. Who are you to tell a willing buyer they can't make that choice?

I do agree that they shouldn't break down people's doors to repo the goods, and I'd have no problem charging the guys who do it with the appropriate criminal offenses. Unless, that is, the contracts give them the right to enter a building by force to retake the property. Do they?

Speaking of usury, Mr. Hempton, hopefully we will see some future input from you on the current/impending hubbub surrounding Fannie and Freddie. (Usury in regard to the 10% divvies via senior pfds)

With the recent budget release we see F&F will stay off the books at least this year. Also a H.U.D.rep stated that the white house 'pledged' to release plans on the future of the GSEs, not coinciding with release of the budget, but in the first week (or so?) of Feb.

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The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.